In honor of the summit, I thought I’d post a link to Colm’s last piece in the Sunday Independent, which hasn’t yet had a thread of its own.

Summiteers, please remember: just because a particular “solution” seems politically necessary, that doesn’t mean that it makes any economic sense at all. If you really want to save the euro (as opposed to enabling it to hobble along for a few more weeks, months or years), then shouldn’t reforming the mandate of the ECB be at the top of your agenda?

Taoiseach Enda Kenny has publicly opposed the need for treaty changes and that remains the Government’s official position in advance of the summit.

However, there is a realisation among senior Ministers in Dublin that Dr Merkel’s commitment to treaty change and the backing she has received from French president Nicolas Sarkozy may have made that process unstoppable.

So, in a Union of 27, if Merkozy wants a new Treaty requiring an Irish referendum then, the IT assumes, this is what will happen. They are quite possibly right.

This should remind us that there are political objectives which the 25 should have in any new Treaty negotiations as well as economic ones. (If we are going to have a referendum, this will take time, and create uncertainty, anyway: so why not get it right?) Economically speaking, if you want EMU to survive in more than the immediate short run, you should logically want a new mandate for the ECB, and some method to provide counter-cyclical adjustment in depressed regions. (I guess we are not going to get this, and indeed we are probably going to get the opposite of this.) Politically speaking, we need moves to reaffirm the primacy of the Community method, or it will be more than EMU that is endangered in the long run. I guess we’re not going to get that either. Of course I would love to be proved wrong.

Before he became über-famous for his history of finance, The Ascent of Money, Niall Ferguson made his name in academia writing ‘counterfactual histories‘. Counterfactual histories are essentially ‘what ifs’, changing the outcome of one or two pivotal events, and taking history for a ride to see where subsequent events take you. A great example is what would have happened if Arch Duke Ferdinand hadn’t taken a bullet to the neck in June 1914 from Gavrilo Princip. Would World War 2 have started? Another cool example is the effect on bridge engineering if ‘Galloping Gertie’ hadn’t collapsed in 1940. Counterfactuals are useful because they allow us to explore the ramifications of what might have happened in the light of what actually happened.

Every citizen in the State has probably sat down at some point asked themselves what might have happened if the late Brian Lenihan hadn’t handed out the blanket guarantee in September 2008 that put the taxpayer on the line for the banks’ many failures. Everyone wonders what would have happened if the Regulator had done his job properly during the years of the construction bubble. And everyone on this blog, I’m sure, has wondered what the outcome would have been if we had burned some of the senior bondholders in bust banks like Anglo long before now.

Official wisdom, as handed down from the ECB as recently as yesterday, holds that confidence in the banking system is more important than individual banks’ liabilities. So the taxpayer must be put on the hook for those liabilities in extremis. Serious people the length and breadth of the country queued up to endorse this policy. If you didn’t–especially if you were an economist–you were being irresponsible and extremist.

Today’s Sindo column by Colm McCarthy puts nails in the coffins of the serious people and their preferred policy. The counterfactual element comes through in this piece quite strongly. Colm argues, clearly and simply, that paying off bondholders of bad debt warehouses when the country is bust and within an EU/IMF loan facility is bonkers, and that there is a different way. Read the whole thing, but here’s a key part:

It is unprecedented for bondholders in defunct banks to be paid by a country already in an IMF programme and unable to re-finance its own sovereign debt in the market.

It is an extra irritation to have to endure lectures from EU and ECB officials about their generosity to Ireland, as if the lucky beneficiaries were the Irish public.

The Irish Times interviewed departing ECB executive council member Juergen Stark and reported on Monday last: “He is dismissive of a renewed Government push to avoid repaying about €3.8bn of the senior debt in Anglo Irish Bank and Irish Nationwide Building Society. The ECB remains opposed to such an initiative and Stark says Ireland is ‘not autonomous to take this decision’. The question is a ‘non-issue’ for the bank.”

The phrasing is interesting. Ireland is “. . . not autonomous to take this decision”. The government of an EU member state, accountable to its electorate, is not free, according to Stark, to decide whether or not creditors in utterly insolvent and defunct banks, no longer trading and in wind-down, should be paid by a Government which has not guaranteed these debts. The funds to pay these bondholders are being provided by the IMF and EU, since the country cannot borrow elsewhere. Each payment adds to a debt mountain already so large as to threaten the ability to service the State’s own sovereign debt.

This column would have been heresy, even one year ago. Now let’s hope it contributes to a change in official policy with respect to the bondholders in Anglo, and perhaps in other banks. Colm closes his piece well, it’s worth quoting:

It is bad enough to have to “take one for the team” without acknowledgement. It is much worse to see the team lose the game so ingloriously.

Good news, it seems, from the Commission, allowing us to extend the maturities of our loans, and service them at much lower interest rates, essentially the cost of funds from the EFSM. It also looks like there will be a retrospective reduction (but that’s my reading of the text, I’m open to correction).

The Commission proposes to align the EFSM loan terms and conditions to those of the long standing the Balance of Payment Facility. Both countries should pay lending rates equal to the funding costs of the EFSM, i.e. reducing the current margins of 292.5 bps for Ireland and of 215 bps for Portugal to zero. The reduction in margin will apply to all instalments[sic], i.e. both to future and to already disbursed tranches.

Furthermore, the maturity of individual future tranches to these countries will be extended from the current maximum of 15 years to up to 30 years. As a result the average maturity of the loans to these countries from EFSM would go up from the current 7.5 years to up to 12.5 years.

Two comments. First, this is very welcome news, and well deserved given the levels of austerity we’ve endured and the cooperation the Irish State has given, relative to other EU countries. Second, were this proposal to come from the Irish side, rather than the Commission, in the current climate it would be seen as a call for a controlled default. The fact that we (and our Portugese cousins) are being allowed to do this shows that the EU Commission is aware that the sustainability of Ireland’s and Portugal’s public finances are in question, and they have decided to act decisively to change the probability of our finances becoming unsustainable in the medium term. So: a good news story for once. Commenters may have differing views, of course.

This report from the Guardian is consistent with Thomas Klau’s argument that current eurozone governance arrangements are pushing “democratic debate and voters’ choices to the margins”. It also suggests that in the long run the present way of doing things will prove politically unsustainable, in a union of democratic states. Whether Klau’s preferred solution is likely to come about is another question entirely.

“There is a commitment that if countries continue to fulfill the conditions of their program the European authorities will continue to supply them with money even when the program is concluded,” Noonan told Irish state broadcaster RTE.

“The commitment is now written in that if we are not back in the markets the European authorities will give us money until we get back in the markets.”

In the event that the State cannot fund itself on the open markets, this statement would seem to imply the Minister readily expects more cash than previously agreed with the EU, IMF, UK, and Sweden. But apparently that’s not a new bailout.

Presumably this statement was intended to reduce uncertainty about Ireland’s post-2013 funding position. But these statements inject more uncertainty.

The Minister expects there will be more cash if we are good boys and girls. Ok, I can accept that. But there are important follow on questions: That’s more cash, for the same terms? On different terms? Cash from whom, using what mechanism (EFSF/EFSM/IMF/Something else)?. When, if not in 2013, will Ireland return to the markets? Is there a Greece-style road map somewhere for Ireland?

Can we see it?

These are just some of the questions raised, on the night at Macgill Summer School we hear the Taoiseach proclaiming Ireland’s intention to repay all of its creditors. which, if we’re Greece 2.0, wouldn’t be correct at all.

Colm McCarthy writing on these, em, pages, a few days ago explained that Europe’s Plan A–no banks will go under, no states will default on their debts, fiscal consolidation plus recapitalisation will see us through–is being quietly dropped in favour of Plan B. Today at the EU Debt Summit we got a glimpse of what Plan B will look like. (updated to official version).

Briefly, Greece is being allowed to selectively default, but this won’t harm Greek banks (nor their French owners) because the greek bonds will be guaranteed by an enhanced European Financial Stability Facility (EFSF) that can intervene in secondary markets amongst other new powers. Other debt-laden member states, including Ireland, will have access to cheaper funds from the uber-EFSF at longer maturities.

The markets liked it too, with bank shares enjoying a nice bounce. There’s some evidence the bounce we saw on the markets was just short equity positions being cleared out, so I wouldn’t take that too seriously as an indicator of how well this new plan will go down. I don’t think many people were surprised at Greece’s default. As macroeconomic events go, the default was pretty well expected, hence the lack of jitters when it was announced.

It is to be welcomed that the Greek default is somewhat orderly and buttressed by other member states’ guarantees to reduce (or avoid completely) balance sheet contagion. What’s not so welcome are some of the phrases used in the draft document. They are vague enough to allow lots of leeway should policy makers require it, but precise enough to guarantee action of some shape or form. All this does is move debate away from ‘what will they do’ to ‘how are they going to do it’, which is unhelpful given the seriousness of the situation. This is, after all, the tenth time EU leaders have met to sort the problems in Europe out ‘once and for all’.

Paragraph 7 of the draft contains the following rather ominous sentence:

To improve the effectiveness of the EFSF and address contagion, we agree to increase the flexibility of the EFSF, allowing it to:

– intervene on the basis of a precautionary programme, with adequate conditionality

That is really worrying language. Does it mean, for example, that the EFSF can require states to implement austerity measures without negotiation with the sovereign? The language is vague enough to be quite scary.

The composition of the new beefed up EFSF isn’t reported. The only place Italy is mentioned in the draft is to get a pat on the back for its recent fiscal consolidation. Is Italy, in its current fragile state, expected to keep its share of the EFSF up? Look at the table on page 1 of this document from the EFSF showing the contributions of member states. Italy is expected to pony up up to 78 billion euros if required. More information on just where this money is coming from would be most welcome.

Another slight worry is that Ireland has agreed to talk about the common consolidated corporate tax base (ccctb), meaning that perhaps there has been a movement in the government’s position on this issue, though agreeing to talk does not mean that Ireland’s corporation tax rate (a different beast) is under threat just yet.

All in all, a lot to discuss in today’s announcements, but I don’t personally feel the EU has solved its problems to the satisfaction of all, though commenters may of course disagree.

Plan A has failed to create circumstances in which the three ‘rescued’ countries can return to the markets, the over-riding objective of any programme of official support. Their traded debt has collapsed in price and all three are rated junk by at least one of the bond-rating agencies. They will not be graduating from the programmes of official support anytime soon and the verdict of the markets, the only verdict that matters, is that Plan A is also junk.

The essence of Europe’s Plan A, as first applied to Greece, is to pretend that the problem is less serious than is actually the case, avoid any element of debt relief and insist that budgetary stringency alone will do the trick.

…

Persistence with Plan A and blaming the markets and ratings agencies is not a viable option should Spain and Italy go under. The game is up. Plan A is being quietly abandoned. In this sense, this has been a good week for Ireland.

..

Minister Noonan should now be seeking European support for an end to payments to holders of bonds, guaranteed or unguaranteed, in the Irish banks. Every cent paid to them is at the expense of the holders of Ireland’s sovereign debt, who have been treated in quite cavalier fashion at the behest of the European Central Bank and apparently in response to threats from this unique organisation.

ECB officials come and go but sovereign states need sovereign credit forever. It would be an unmitigated disaster if Ireland’s act of faith in Europe were to result in the first-ever default on the sovereign obligations of the State.

The European Commission, European Central Bank, and International Monetary Fund have passed Ireland with flying colours in their latest quarterly review. I’ll post audio of their press conference when it’s available (commenters please drop the link if you see it). The IMF press release is here.

The statement reads that bank reforms are on track, fiscal consolidation is on track, structural reforms are to come, and it’s all good. Lots of touchy-feely language. Those pesky bond markets, and the burning of senior bondholders, weren’t looked too kindly upon in questions, but overall the message seemed to be: Nothing to see here, nothing at all, no to burning senior bondholders, but guess what lads, the next review will be tougher. Stick with the programme.

On twitter, NamaWinelake reported a divergence between the EU and IMF, with Ajay Chopra of the IMF saying he expected to see a more robust approach to burden sharing, while the ECB representative said no, that wouldn’t be happening. Although much can be made of comments like this, the review exercise seems to be, on balance, a qualified success. The government did meet its agreed targets. Whether the exercise enhances our credibility to the point that Ireland can wean itself off EU and IMF funds without a second loan package is another question entirely.

The pre-2007 Irishman abroad in Europe had a little swagger to him. He thought his economy was a Tiger. When abroad in Europe, he spent like crazy, and generally annoyed his European counterparts with his brash ways. (Of course I’m not thinking of anyone in particular). The reverse is happening at the moment. We’re humble little chappies. My French and German friends are sending me emails with pictures of the Book of Kells saying ‘please take care of our investment’ and ‘are you enjoying your bailout?’ and ‘we’re still waiting for the thank you card’.

They’ll be waiting a while longer. When I say our European friends should be thanking us, they assume it’s a throwback to the hubris of pre-2007 Ireland or something to do with keeping eyes off the balance sheets of German and French banks. It’s not, and here’s just one reason why.

Given the recent discussions of the views of Professor H-W Sinn on this site it seems only right to point out that there are also other opinions in Germany. A number of current and former German politicians (Helmut Schmidt, Joschka Fischer) have been critical of the leadership provided by key politicians. Now the former finance minister Peer Steinbrück (still an active opposition politician) has found some clear words: “Greek default is inevitable – lets call a debtors conference.”

LBS’s many fans on this Blog will want to read about the controversy surrounding his continued membership of the ECB’s Executive Board. If he does not step down Nicolas Sarkozy is threatening to block Mario Draghi’s accession to the Presidency. The Financial Times account is here.

Silvio Berlusconi has called on him to step down, although no definite decision has been taken to offer him the post as head of Banca d’Italia in succession to Draghi.

According to the Corriere della Sera LBS had ‘no comment’ about the issue on leaving the palazzo Chigi. However, La Repubblica quotes him (on leaving a conference in the Vatican) to the effect that he cannot be removed before the end of his eight-year term. He underlined that ‘personal independence is one of the doctrines on which the independence of the Bank rests.’

The series is named after Ryszard Kapuscinski, a Polish reporter and writer who was a “Voice of the Poor” in his famous reportages and books covering the developing world.The lecture series is organized jointly by the European Commission, the United Nations Development Programme and partner universities, in this case TCD and UCD.Ms Barbara Nolan, Director of the European Commission’s Representation in Ireland will open the Dublin Kapuscinski Lecture 2011 on ‘Climate Change and Development’.

Professor Dirk Messner, German Development Institute, will deliver the keynote lecture.“The global development panorama is changing dramatically. The challenges of security and poverty are more interwoven than ever before. Yet, two thirds of the global poor people are now living in middle income countries like China, India and Brazil. What does this new global poverty map imply for European development policies? Development trends are also embedded in an overall global development challenge: – climate change. The world needs to learn to decouple wealth creation from burning fossil fuels. A great transformation to a global low carbon economy is necessary during the decades to come in order to avoid major and dangerous changes in the Earths system. What do these global shifts imply for Europe s role in the world? Europe needs to define its global interests. And it needs to be part of a global governance strategy to shape global development trends.”

In the Eolas piece I looked at Ireland’s policy options taking the European bailout/bail-in regime as exogenous (albeit uncertain).Of course, a different question is what we would want that regime to be, one now being hotly debated given Greece’s new difficulties.

A central focus in the recent debate is the proper extent of early private sector involvement (PSI) in bail-ins.Looked at from an Irish perspective, a range of considerations come into this calculation: (i) the reputational damage in a debt restructuring/default; (ii) the ultimate reduction achieved through a restructuring in the net resource transfer; (iii) the risks associated with increased dependence on official creditors and their domestic politics; (iv) the risks of domestic and international contagion; and (v) the implications for future market access of a weakening of the implicit guarantee given to private creditors.

I think the last of these points deserves additional discussion.At the moment we seem to be between two stools.Early PSI is ruled out; but PSI is central to the post-2013 ESM regime, substantially weakening the implicit guarantee and scaring off potential new creditors.Thus there is a certain incoherence at the heart of European policy. It also is a particularly bad combination given the trade-off involved with any resolution regime: it is good to be able to share losses with private creditors ex post; but a regime with easier loss sharing will weaken the implicit guarantee and make you less creditworthy ex ante.

We need European policy makers to move one way or the other, either allowing early PSI before a substantial amount of private debt is paid back, or providing clarity on the nature of the implicit guarantee that gives a feasible route back to the markets for countries that follow through on their adjustment programmes.The ECB seems to be calling for a full guarantee by effectively ruling out defaults.This seems neither likely nor desirable.However, further clarity on the way PSI will be applied in the future, with a reasonable path to avoiding it, would give a country a chance of regaining market access and not having to resort to default.It is probably unfortunate for us that policy precedents are being set in this area based on the quite different Greek situation.

Much of the pessimism about Ireland’s predicament has centred on the challenge of stabilising the debt to income ratio.Undoubtedly this will be challenging, with good outcomes on nominal GDP growth and fiscal adjustment capacity required. Of course, it has been made much more difficult by the massive bank losses the State has had to absorb.But I think a focus on the stabilisation challenge misses a critical issue, which is regaining market access at a high if stable debt to GDP ratio (probably somewhere in the region of 120 percent of GDP).

Martin Wolf’s column from last week provides a useful starting point for a diagnosis of the problem – an article that garnered all of one comment on the blog (from DOCM).It draws on Paul de Grauwe’s insightful work on the susceptibility of countries in a monetary union to a debt crisis (see here), where a country without its own currency and central bank to act as lender of last resort is vulnerable to self fulfilling expectations that it will not be able to roll over its debts.The EFSF/ESFM/ESM were put in place to help fill this LOLR gap, but have so far proven to be a poor substitute.It is understandable that Germany and other likely net funders want to eventually reinstate market discipline, and so demand losses are borne by private creditors as part of any new bailout.It is also understandable that they want to protect themselves from losses under the permanent bailout mechanism (the ESM) by demanding preferred creditor status. But it is becoming increasingly evident that crisis-hit countries will find it extremely hard to regain market access with a half-hearted LOLR facility in place given any doubts that they will not be able to pass a debt sustainability test under the ESM.

The official funders have to be willing to take on some additional risk if a mutually damaging combination of default and ongoing dependency is to be avoided.One element is to clarify the way the debt sustainability test will be applied.A current problem is that austerity measures weaken growth, thus making it harder to pass the test.A useful amendment would be to assess growth in the debt sustainability calculation assuming a neutral fiscal stance.Another useful amendment would be to set a ceiling on the size of any haircut, thereby limiting the uncertainty faced by potential new investors.

As a quid pro quo for these amendments the government could offer to speed up the fiscal adjustment (along the lines recommended by the ESRI in its Spring QEC).Of course, more fiscal adjustment is the last thing the economy needs as it struggles to pull out of recession.Yet a quasi-permanent loss of creditworthiness and dependency on unreliable official support looks to be the bigger threat, as it saps confidence and undermines the perception of the economy’s stability.Those resisting fiscal discipline must realise that the situation changed profoundly when Ireland’s creditworthiness disappeared in the second half of last year.Some observers are putting forward the same fiscal policy prescriptions as they did when bond yields were around 5 percent.They must see that the ground has fundamentally shifted.

It is hard to see how further public sector pay cuts could not be part of any balanced additional adjustment.A credible new regime for long-run fiscal discipline is also essential.

The government should take the offensive in pointing out the incoherence of the current international support approach, while avoiding playing a self-defeating grievance card.What is needed is a hard-headed look for a mutually advantageous set of policies that allow Ireland to shed its dependency.The first step is a proper diagnosis of creditworthiness challenge.

Colm McCarthy makes some important political points in today’s Sunday Independent. He points out, quite correctly, that the ECB’s policy of favouring an Irish sovereign default later over a private banking default now (and it is important to be clear that this is exactly their position, whether or not they publicly admit it) is going to make it very difficult, if not impossible, to get public buy-in for the further austerity measures coming down the line; and is also virtually certain to lead to increasing anti-EU sentiment here (and in the rest of the periphery as well).

But it’s worse than that. By confusing fiscal and banking crises in the public mind, the ECB is also fuelling anti-EU sentiment in the core, since core taxpayers understandably resent the notion that they should subsidize feckless peripheral taxpayers. By contrast, greater honesty about the fact that we have a Europe-wide banking crisis would make taxpayers everywhere realise that they have common interests, and a common enemy, namely an out-of-control financial sector. In such a scenario, ‘Europe’ might be seen by ordinary voters as having something positive to contribute, since cross-border banking requires cross-border regulation. Right now, however, ‘Europe’ is seen as a big part of the problem, in the case of the ECB correctly so.

Shamefully, it has taken me several weeks to realise the full import of the attached Irish Times piece by Garret FitzGerald. He has for many years sought to draw the attention of the Irish public to the role of the European Commission as defender of smaller states’ interests. Here he warns, in much more modest language than that with which I have entitled this entry, that the current German-French proposal for euro zone reform “represents a new attempt to bypass the union’s tried and tested decision-making system… There is a new danger that the decision-making system that for over half a century has sustained and kept in balance an inherently cumbersome union… may lose its hitherto carefully preserved cohesion, and for the first time become dominated by some larger states.”

The FT is reporting that the Christine Lagarde is the latest high-level official to offer tentative support forbond purchasesby the EFSF as a central element in the reform of liquidity support measures.

Christine Lagarde, French finance minister, said France was ready to discuss allowing the eurozone’s €440bn ($588bn) bail-out fund to start buying bonds of struggling European economies amid signs of consensus that it would become the primary new tool for tackling Europe’s ongoingdebt crisis.

How significant a development would this be?The first thing to note is that ECB bond purchaseshave failed to bring market yieldsto affordable levels.While probably helping to a degree, the ECB’s secondary-market purchases have lacked commitment and provide no real certainty to investors on how high yields could rise. Secondary market purchases by the EFSF are unlikely to be much more effective unless operated at a very different scale.

In principle, however, officialprimary-market bond purchases could provide guaranteed funding at some maximum interest rate.This maximum rate could be set high enough to create strong incentives to rely on market funding. I would presume that the total amount of funding would be capped and the programme would have a time limit.But because they involve purchases of ordinary bonds, concern about the seniority of official creditors should be lessened.Overall, the existence of such an official buyer of last resort should give market investors reasonableconfidence that governments would be able to roll over their borrowing as bonds mature over a significant time period.The proposal has the potential to provide support to a country facing difficult market conditionswithout crowding out longer-term private investors from the market; such crowding out appears to be a major shortcoming of current support measures.

Of course,the devil is in the detail,and there is little concrete yet about how such bond purchases would actually operate.It is also unclear whether these new facilities would be available to countries already in support programmes.But it is an interesting development.

One of the disappointingthings about the bailout and associated adjustment programme is that it has done little to lower the perceived probability of an eventual Irish default.I know that many readers believe Ireland is fundamentally insolvent, and so are not overly surprised.At this stage, however, there is growing recognition that the structure of the European bailouts also makes it difficult for countries to regain market access.Key European policy makers have indicated a willingness to revisit the arrangements, though this will have to go beyond the relatively straightforward option of increasing the size of the support funds.

I grapple with the reasons why the current structure of the bailouts is itself an impediment to regaining creditworthiness in a piece for the business sectionof today’s Irish Times (article here).

Paul Krugman has a thoughtful survey of the Euro crisis in this week’s New York Times Magazine (forthcoming on Sunday but available on-line now). This is not stockbroker-economist-type research, which tends to be long on buzzwords and hyperbole. It is a well-reasoned feature-length review with some policy suggestions.It has a central focus on Ireland and the other troubled peripheral states.

John Bruton has an interesting opinion piece in the Irish Times – the headline is “Europe also responsible for Ireland’s Banking Crisis”. He is of course absolutely right to point out, as others have done, that this crisis would not have happened if German, UK, Belgian and other banks had not lent to Irish banks, just as much as it would not have happened if Irish banks had not lent to Irish developers. What he does not point out is that other EU members benefitted greatly from the Irish boom e.g. where were the BMWs, Mercs, Audis etc. built?

John Bruton is very critical of the EU response and highlights that it is very narrow and one sided. For example he points out that the agreement reached at the last summit only provides a mechanism for help if the crisis threatens the entire Euro-zone – no scope to help out countries hit by an asymmetric shock. He also points to other crises facing the EU that need serious action.

To me the approach taken at the summit (and during other recent decisions) implies a departure from the principle of solidarity between the EU members that was supposed to underpin the EU. Of course all EU members can start looking after domestic interests only – Angela Merkel might end up with a nasty surprise the next time she is looking for a decision that requires unanimity. In that sense, far from solving problems, the last summit has added more uncertainties for the EU. No doubt the markets will use the Christmas break to sharpen their knives!